Thursday, October 23, 2008

Why The Bailout Is Failing

The equity markets have passed judgment: The Bailout is Failing.

The current list of Bailout Failure symptoms is large: Declining markets, historically large spreads, and etc. The underlying cause of all of these symptoms is that confidence in the financial system has been shattered.

Sadly, several Fed actions have exacerbated the situation. For instance the Fed has proposed numerous facilities to jumpstart credit. Naturally, every time a new facility is introduced, a portion of the credit sector shuts down, since no sane business would ever continue issueing credit in competition with the Fed. As parts of the credit food chain are subsumed by the Fed, businesses shut down their operations in the next part of the credit food chain, which the Fed has just made nonviable. Consequently, the Fed needs to create another facility for that newly shut down operation. And so on.

Underlying all of these issues is the fact that there are many insolvent institutions. Ben Bernanke, who is a student of the depression, knows well that runs on financial institutions occurred due lack of confidence in the 1930s. Once the system was reflated in 1933-4, reconstruction could begin.

However, it seems lost on him that a major aspect of the reflation is that the insolvent institutions had already been removed from the system by 1934. At the moment, there seems to be not even a whisper of shutting down the large banks that were so incompetent that they drove their businesses into bankruptcy. We are even rewarding those institutions by augmenting their shareholders with government capital. (Let's face it: It's not likely that these banks are going to suddenly grow new neurons and become smart and sensible operations.)

We should not expect any real change until we remove the rot from the system; it is the underlying cause.

Tuesday, October 14, 2008

Paulson Capitalism

Welcome to the new banking system in the United States. A quick scan of the headlines will tell you that major banks are being partially nationalized. You may remember that this nationalization is in response to the fact that they are insolvent.

Most businesses do not strive to achieve insolvency. In the case of the banks, they managed to find themselves in this state by being badly mismanaged and making poor investments.

The UK recently taught Paulson that (a) his plan to prop up balance sheets by buying toxic waste was flawed (in truth, he just has a big conflict-of-interest as former CEO of Goldman-Sachs) and (b) government taking equity was the proper way to inject capital. The UK version creates obvious dilution for the shareholders and takes board seats in order to clean house of poor management.

Secretary Paulson, in his infinite wisdom, has decided that the current banking management is just fine, their results are not worthy of castigation by firing squad, and that shareholders are to be "protected". Like many statements from the Bush administration, you need to spend time to figure out how they are torturing the language in order to see through to the truth. The truth here is that Paulson is diluting the shareholders as well as addressing symptoms rather than the cause.

The bailout details are actually pretty simple. The Treasury will inject 20-25 billion dollars in each of 9 major banks and take out "perpetual preferred" stock. In the event of bankruptcy, or receivership, these shares stand ahead of the common shares. The shares also pay a dividend. From the NYT:
The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock.
By any reasonable definition of dilution, shareholders should be angry about the warrants. It means that any future increase in stock price will be shared with the government (who will sell those shares and drive the price down.)

From the viewpoint of the economy, the most interesting part of the deal is the 5% dividend. By forcing the banks to take this money, they need to earn at least 5% on the money in order to turn a profit. So they collectively need to figure out $250B in investment deals. Naturally, since they have proven themselves to be such good investors in the past (why do they need a bailout?) they will scour the planet in search of returns. The alternative is for management to find quick investments, continue cooking the books (mark-to-market rules are now suspended), collect bonuses and have cushy jobs. Which do you think is the more likely outcome?

In summary, Paulson thinks that the same management with a demonstrated capacity to lose a trillion dollars is going to somehow grow new neurons and be smarter with the taxpayer's $250B. Good luck with that.

Monday, October 13, 2008

Heckuva Job, Brownie! (Gordon Brown, of course.)

1. For Gordon Brown, I just have to say: Heckuva job, Brownie. Really.

2. England just schooled Hank and W on how to execute a honest-to-god bailout, not the Friends of Hank bailout that was passed by congress a mere 10 days ago.

3. Now that British banking is more secure than US banking, expect the giant sucking sound of money leaving the US for Europe until either Hank wipes out US bank shareholders with partial nationalization or Obama takes office.

Why is Hank avoiding this solution? Look at the share prices of the banks that received gov't money: They were pummeled. Hank would be wiping out many of the colleagues on Wall Street that helped make him CEO of Goldman-Sachs. He just doesn't have it in him.

Monday, October 6, 2008


I will be experiencing life on the road for the week of Oct6-Oct10. I hope for some live, action photos of the TARP rescue working its magic on middle America.

Thursday, October 2, 2008

You Have Been Officially Shafted in this Trainwreck

Perhaps you've heard that the Senate decided to pass the trillion-dollar bailout bill that the House rejected earlier this week. Obviously, our wise and prudent Senators would not be so foolish as to pass that old rejected bill with its stale and unfashionable provisions. That would be an insult the House. Therefore, changes were required.

If you watched the CSPAN debate over the bill Wednesday night (you really need to get a life, don't you think?), you were treated to much bloviation about trains. As the public has been told repeatedly, the Welfare for Wall Street bill is maximally urgent. We can only assume that the elongated discussion about trains is to prevent this legislation from causing the very trainwreck which it seeks to prevent. Sadly, I was unconvinced.

As my mind wandered from the wise words spoken on the floor of that hallowed chamber, I decided to see what modifications might have been added. Via the most excellent Calculated Risk and Naked Capitalism blogs, we find the heart of the changes:

(a) IN GENERAL.—Paragraph (2) of section 4161(b) is amended by redesignating subparagraph (B) as sub301 paragraph (C) and by inserting after subparagraph (A) the following new subparagraph:

‘‘(B) EXEMPTION FOR CERTAIN WOODEN ARROW SHAFTS.—Subparagraph (A) shall not apply to any shaft consisting of all natural wood with no laminations or artificial means of enhancing the spine of such shaft (whether sold separately or incorporated as part of a finished or unfinished product) of a type used in the manufacture of any arrow which after its assembly—

‘‘(i) measures 5⁄16 of an inch or less in diameter, and
‘‘(ii) is not suitable for use with a bow described in paragraph (1)(A).’’.

(b) EFFECTIVE DATE.—The amendments made by this section shall apply to shafts first sold after the date of enactment of this Act.
I realize that the Senate is voting to bail out banks and shaft the next three generations of Americans, but I really never expected them to say it this plainly.

Then, came the exciting moment: The moment where voting occurs and we watch democracy in action. Apparently, the Senate was never wired for electricity, because while we are hearing about urgency (OMG! HARRY REID SAYS THAT A MAJOR INSURER IS GOING BANKRUPT SOON! WE NEED TO PASS THIS NOW!) these wise men and women cast their votes in the same manner as the Greeks, by calling out a name and writing longhand on a piece of paper. I really don't understand why we think that 100 grown men and women that can't bring themselves to vote electronically have any insight into how to spend a trillion dollars on bailing out Wall Street.

Seriously folks, if you want any hope of the House dealing with this problem of our generation in an intelligent and just manner, you need to call your representatives at (202) 224-3121 and threaten to vote them out of office next month unless they ditch the current plan. The fundamental flaw is that the plan still has the structure proposed by Secretary Paulson, former CEO of Goldman Sachs, who will profit handsomely from this legislation. He is sending a gift to banks for making bad investments.

There is an age-old and intelligent way of dealing with insolvent institutions, and Paulson is avoiding these solutions, as it would bankrupt many of his colleagues. However, if we are to restore confidence in the banking system, we need to clean house, not buy crappy assets above market value. The current solution will only convince investors to leave the market, selling their stock as they go.

We cannot coddle the failures on Wall Street: If you have a bad company that is taking down the financial system, wipe out the shareholders, haircut the bonds, fire the board and CEO, recapitalize, and reboot.

Wednesday, October 1, 2008

U.S. Decline Under Bush Is Hot Topic at U.N.

The Paulson bailout is beginning to have ripple effects on world affairs:U.S. Decline Under Bush Is Hot Topic at U.N.:
"Not only are U.N. diplomats worried about the spillover of financial damage to their markets, but they find a free market-oriented administration's full-throated backing of a highly interventionist bailout galling, coming after years of Washington hectoring other countries about maintaining economic prudence and counseling against debt bailouts.

'Here's the U.S. engineering the mother of all bailouts,' marveled the diplomat. He says diplomats believe that poor Bush administration policy choices, the lengthy and unresolved military engagements in Iraq and Afghanistan, and the general rise of powers like Russia, China, and India have all eroded U.S. power in relative terms."
Now, I'm not much of a political creature, but if the current administration offered to leave, I'd offer to help them pack.

Forget the history of the past 7 years for a moment. If you were designing a financial intervention, what would it look like? I think good business leaders would try and rip the band-aid off quickly, rather than augment it with duct tape. Certainly, lots of pain will be felt, but not nearly as much pain as when it comes time to rip off that duct tape.

Hey congress! Do something sensible, just this once: If you have a bad company that is taking down the financial system, wipe out the shareholders, haircut the bonds, fire the board and CEO, recapitalize, and reboot.

And stop with the third world bailout tactics. It's unbecoming.